Why Isn’t Value Investing More Popular?

Excuse me for a minute, I’m just going to rip off a lot of this post from the Globe and Mail, the fine place of journalistic integrity that managed to convince me to pay for unlimited access like some sort of chump and/or chumpette. It’s about value investing, because everything around here is about value investing. And boobs.

(You might not be able to access that without a membership to that particular website. Sucka.)

Don’t worry, I’ll quote enough of it to you to get the gist. Study after study has shown value investing works. I pointed it out on this very blog, all you need to do is consistently buy stocks trading at low P/E ratios or P/B multiples. If you buy them all, you’ll beat the market despite yourself.

I do things a little differently, focusing on out of favor stocks and sectors, and erring towards companies with little to no debt. I’m trying to take away the possibility of one of the stocks blowing up, plain and simple. A company with no debt on the balance sheet isn’t about to go to zero.

But getting back to the main issue, if value investing works, why don’t more people do it? The author has a few ideas.

A big reason is that what value investors do is not well known or understood because universities accept the notion that markets are efficient and, as a result, they focus on teaching and applying modern portfolio theory, which cannot be more different from value investing.

I cannot fathom how people think the market is efficient. There will always be opportunities for sharp investors. Stocks will always sell off more than what they should based on short term events. The market generally looks at the short term while discounting the long term. Astute investors can profit from this.

Value investors also take big, concentrated positions, which flies in the face of modern portfolio theory.

The researchers studied about 1,700 actively managed U.S. funds from 1984 to 1999 and 1993-2002, respectively. They found that the more concentrated and less diversified a fund was, the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. They also found that the lower the reliance on public information and the greater the reliance on a portfolio manager’s own skill, the greater the outperformance.

Value investing is about 80% science and 20% art. You’ve got to figure out that an investment is undervalued, but you’ve also got to figure out when things are most pessimistic, and when that pessimism will push the stock to the lowest point. That’s the tough part. I’m constantly early on stocks I like. I’ve learned not to sweat it, since my target prices are often 2-3 times higher than the current price.

Value investing is all about concentrating a portfolio on a few, selected, truly undervalued stocks. Diversification does not matter much; the margin of safety, which helps identify a stock as truly undervalued, protects the downside and controls for risk.

I’m sitting on about 15 stocks right now. I have big positions in all of them. People who own thousands of different companies via ETFs think I’m nuts. But the evidence remains – value investors who have concentrated portfolios continue to outperform.

This brings us back to the original question: If the evidence in favour of value investing is so overwhelming, why isn’t everyone a value investor? Why does a value premium (showing that value, on average, beats growth investing) still exist? This is because the driving forces behind the value premium are human psychology and institutional biases – forces, again, that fly in the face of market efficiency.

I know of very few true value investors. I know a bunch of dividend growth investors who think buying Coke at 18 times earnings is a value investment. But I know very few that would entertain an unloved small cap like Automodular that we all know is disbanding. Because it’s hard to buy Automodular. There are 100 investors who would buy Coke compared to Automodular, mostly because investors are biased toward companies they know.

Like most things in life, value investing rewards hard work and thinking outside of the box. Humans in general don’t do either of those things very well. That’s why we’ll have 14000 Tesla articles for every Automodular story.

2 Comments

JT
on April 10, 2014 at 3:22 pm

“It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is.

I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of I.Q. or academic training. It’s instant recognition, or it’s nothing.”

Excellent post, you made a very good point. This problem reminded me of a psychology research where people were asked whether they’d chose to be given $50 right now, or $100 in three months. Everyone wanted the money now, because who knows what might happen in a few months. I guess it’s in our nature.